District court allows R&D credit for prototype costs.

• Author: Homen, Gregory F.

In a recent U.S. district court case, Trinity Industries Inc., No. 3:06-CV-0726-N (N.D. Tex. 1/29/10), the court held that the taxpayer (Trinity) is, in certain situations, entitled to the Sec. 41 research credit for qualified research expenditures (QREs) for activities relating to the design, development, and construction of new types/classes of ships. Trinity considered these first-in-class ships to be prototypes because the specific designs had never been previously attempted and, once validated and proven to meet their objectives, would be duplicated and commercially produced.

Background

A division of Trinity, Trinity Marine Group (TMG), was in the business of shipbuilding. TMG incurred substantial expenditures developing first-in-class ships for various customers. The complexity of design ranged from new hull designs to mix-and-match combinations of existing components. Regardless of the type of design, none of the ships being developed had been constructed previously. These first-in-class ships were essentially prototypes developed to prove out a design. Trinity claimed the research credit for the QREs related to TMG's first-in-class development efforts on its tax returns for the tax years ended March 31, 1994 and 1995 (when Trinity incurred the expenditures). The IRS disallowed the credit claims. Trinity argued that the claims were wrongfully disallowed, eventually bringing the dispute before the district court.

Because Trinity was not able to offer sufficient evidence for the court to determine QREs for a business component smaller than the entire vessel (Hurricane Katrina destroyed many of the records), Trinity adopted an all-or-nothing approach for each ship and applied the 80% threshold in Regs. Sec. 1.41-4(a) (6). Thus, Trinity would qualify for the research credit only if substantially all (80%) of the costs to build a first-in-class ship were QREs. Using this approach, the court found that of the six ships originally claimed by Trinity, only costs incurred for the development of two ships met the 80% "substantially all" threshold. Although the costs of the remaining four ships included qualified expenditures, the court was unable to apply the shrinking-back rule under Regs. Sec. 1.41-4(b)(2) to qualify any components of those ships because of the aforementioned lack of evidence of costs associated with any component subsets of the vessels. The court directed Trinity and the IRS to confer and work toward an agreement on the...